3: FINANCIAL MARKETS AND INSTITUTIONS

1 Introduction
1.1 When a firm is making its financing decision it has the choice of obtaining finance directly
from investors through the financial markets or indirectly through financial institutions
that they have deposited their money with; these financial institutions act as financial
intermediaries.

2 Financial institutions
Types Functions
Merchant (or investment) Provide large corporate loans, often syndicated. Manage
banks investment portfolios for corporate clients.
Pension funds Invest to meet future pension liabilities.
Insurance companies Invest to meet future liabilities.

2.1 These financial institutions dominate share ownership, and also the provision of debt
finance; because they are investing their clients' money they are referred to as financial
intermediaries.

3 Financial intermediaries
3.1 Financial intermediaries provide the following functions (remember as MAP):

Functions Description

Maturity transformation A bank can make a ten-year loan (long term) while still
allowing its depositors to take money out whenever they
want; so short-term deposits become long-term investments.
Aggregation of funds A bank can aggregate lots of small amounts of money into a
large loan.
Pooling losses Any losses sustained from a bad debt will not impact directly
on an individual depositor. This is sometimes called risk
transformation.

4 Financial markets
4.1 A financial market brings a firm into direct contact with its investors. The trend to borrowing
directly from investors is sometimes called disintermediation.

4.2 Financial markets are split into those that provide short-term finance (money markets) and
those that provide long-term finance (capital markets).

4.3 There is a distinction between primary markets (where companies issue new securities to
investors to raise new funding) and secondary markets (where investors buy and sell from/to
each other).

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5 Money markets
5.1 If a company or a government needs to raise funds for the short term, they can access the
money markets and issue:
(a) Treasury bills (issued by governments)
Increasing
risk to the (b) Certificates of deposit (can be sold on)
investor (c) Commercial paper (issued by companies with a high credit rating)
(d) Bills of exchange (company IOU signed by customer, may be
'accepted') – the process of converting assets into securities that
can be sold is sometimes called securitisation

5.2 Higher risk investments require a higher return to be paid. Commercial paper and bills of
exchange are discussed in more detail later in the course.

5.3 Whilst some money market instruments are interest bearing, others are discount
instruments. An interest-bearing instrument is one where the investor lends or deposits an
amount and receives that amount back plus interest at the end of the investment term. So
an investor lends $100 at 10% and receives $100 plus $10 interest at the end of the
investment.

5.4 A discount instrument is one where the investment is bought for less than face value by the
investor but they receive the face value of the investment at the end of the investment term.

Interest-bearing instruments Discount instruments

Money market deposits – very short-term
loans normally between banks.
Certificates of deposit – a certificate of receipt
for funds deposited at a financial institution for
a specified term and paying interest on a
specified date.
Repurchase agreements – an agreement
between two parties under which one party
agrees to sell a financial instrument to the other
on an agreed date for an agreed price and
simultaneously buy back the instrument at a
later date for a higher price (agreed upon in
advance).
Treasury bill – debt instruments issued by the
Government with maturities ranging from one
month to one year.
Bank bills (or acceptance credits) – sold by
and guaranteed by a bank on behalf of a
company for up to 180 days of credit. They are
not tied to a specific transaction.
Commercial paper – short-term unsecured
corporate debt with maturity of up to 270 days.
Usually issued by the largest organisations with
good credit ratings.
Bill of exchange – an IOU signed by a
customer. It can be sold on the money market
to raise finance. Bills of exchange are only
used for significant transactions (eg above
£75,000).

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Lecture example 1 Exam standard Section A 2 marks

An investor buys a certificate of deposit with a face value of $5,000,000 issued on 1 June 20X6
and maturing on 1 December 20X6 (183 days later). The coupon rate is 8%.
Required
What is the maturity value of the certificate of deposit to the nearest $'000 (assuming a 365-day
year)?
A $5,201,000
B $5,400,000
C $4,630,000
D $4,807,000

Solution

6 Capital markets
6.1 If a company needs to raise funds for the long term, it can access the capital markets; this
is a market on which the following are traded:
(a) Bonds/loan notes (secured on an asset or by covenants)
Increasing (b) Junk bonds (unsecured)
risk to the
investor (c) Shares traded on the main stock market
(d) Shares in the Alternative Investment Market

6.2 Higher risk investments require a higher return to be paid, so shares will give a higher return
(and therefore cost more) than bonds. Bonds and shares are covered in more detail later
in the Course Notes.

Lecture example 2 Idea generation

Required
What advantages are there to a firm of:
(a) A listing on the main stock market?
(b) A listing on the Alternative Investment Market?
(c) Issuing bonds?

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Solution
(a)

(b)

(c)

7 Risk and reward

7.1 Rational investors accept greater risk only if the rewards are appropriately larger. The bigger
the risk the bigger the reward should be. Conversely if an investment exposes the investor
to little risk then the returns should be lower than for a medium- or high-risk investment.
7.2 Normally lenders bear less risk than shareholders because lenders have legal rights to
receive interest and repayments of capital and usually rank more highly than shareholders in
the event of a liquidation. Therefore, lenders tend to be happy to receive lower returns (also
known as yields) than shareholders. This is consistent with the basic risk-reward trade-off.
7.3 Sometimes shareholders are happy to receive lower yields than lenders, however. In the
short term shareholders may be willing to accept low short-term rewards (dividend yield) in
the hope of getting greater gains later. This is the reverse yield gap. It can also arise if
firms or governments that are desperate to raise finance offer a yield on their debt in excess
of the yield on shares.

8 Eurobonds
8.1 In recent years a strong market has built up which allows large companies with excellent
credit ratings to raise finance in a foreign currency. This market is organised by international
commercial banks. The key features of Eurobonds are summarised below. This market is
much bigger than the market for domestic bonds.

Advantages Explanation

Cheap debt finance Can be sold by investors, and a wide pool of investors share the
risk
Unsecured, no Only issued by large companies with an excellent credit rating
covenants
Long-term debt in a Typically 5–15 years, normally in euros or dollars but possible in
foreign currency any currency

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Lecture example 3 Exam standard Section A 2 marks

Hoddor plc is a large company and frequently participates in the money markets as both a lender
and borrower.
Required
Indicate which of the following instruments are described in the box below.
Repurchase agreement Money market deposit Commercial paper

Instruments
1 Hoddor plc makes a short-term loan to a bank. The interest
rate has been agreed in advance along with the maturity
date.
2 Hoddor plc sells an unsecured debt instrument which
matures in 180 days, after which it redeems the instrument
at face value.
3 Hoddor plc sells some shares to Cersei plc for $1m on
1 May 20X6 and agrees to buy the shares back from
Cersei plc for $1.05m on 1 November 20X6.

Solution

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Additional Notes

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9 The role of the treasury function

In most large companies the treasury function provides four key functions:
1. Managing liquidity – short-term cash flow surpluses and deficits (Chapter 6 working capital
finance)
2. Managing funding – both short term and long term (Chapters 12 and 16)
3. Managing risk – this is covered in Chapters 19 and 20
4. Advising on corporate finance issues – eg dividend policy (Chapter 12), business
valuations (Chapter 17)
Centralised or decentralised?
If the treasury function is decentralised this can mean that:
 Divisions have more autonomy
 Treasury is quicker to respond (divisional)
However, the treasury function is normally centralised, which brings a number of advantages:
 Economies of scale
 Expertise
 Netting of divisional cash flows – to minimise external borrowing
 Matching divisional cash flows – to minimise currency hedging

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10 Chapter summary
Section Topic Summary
1 Introduction When a firm is making its financing decision it has
the choice of borrowing sources.
2 Financial These include merchant banks.
institutions
3 Financial Institutions are investing their clients' money, they
intermediaries are financial intermediaries; this allows Maturity
transformation, Aggregation and Pooling of losses.
4 Financial These consist of the capital markets and money
markets markets.
5 Money The markets for short-term funds eg commercial
markets paper, bills of exchange.
6 Capital The markets for long-term funds eg bonds, shares.
markets
7 Risk and The return required by investors will rise as risk
reward rises.
8 Eurobonds Allows companies with an excellent credit rating the
ability to borrow in a variety of different currencies.
9 Treasury Large companies use a treasury department mainly
function to manage risk and liquidity.

END OF CHAPTER
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